TO SAVE the economy from a financial implosion, the United States Federal Reserve has adopted 'quantitative easing' (QE), an extreme form of monetary easing that pushes interest rates to 0 per cent so as to flood the system with excess liquidity. China has also implemented a form of QE, Chinese style. Japan implemented QE from March 2001 to March 2006 in an attempt to save its economy from a deflationary spiral. Japan's experience holds valuable lessons for the US and China.

The Bank of Japan (BoJ) raised the level of its current account balance to 35trillion yen (S$560 billion) during the QE period, well above the one trillion yen needed to keep the overnight rate at 0 per cent. Through open market operations, it bought long- and short-term treasury bills, bonds, asset-backed securities and even equities. The BoJ said that QE would remain in place until the non-food consumer price index stabilised at a positive level. But the efforts failed to boost credit growth and reduce risk aversion. While QE boosted the monetary base, its expansionary impact failed to spill over into the broader economy. This was because Japanese banks were unwilling to extend loans. They simply parked their excess reserves in risk-free BoJ accounts. Though Japanese bank lending stabilised in 2006, it has yet to return to a healthy growth rate. The only outcome of QE was to drive down long-term Japanese government bond yields to very low levels (1.33 per cent at the time of writing).

The failure of Japan's QE was the result of earlier policy mistakes. The authorities had kept both monetary and fiscal policies too tight for too long. The BoJ even hiked rates after the stock market bubble burst and kept them elevated for 18 months before easing in mid-1991. There was no decisive fiscal expansion for some years, and QE did not start until March 2001, 11 years after the asset bubble burst.

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